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The New York Appellate Division for the First Judicial Department reversed a Supreme Court order holding that insurers of a law firm were not obligated to defend and indemnify the firm under excess professional liability insurance policies. The relevant facts are described in the court's opinion:

The law firm Pepper Hamilton and one of its members, W. Roderick GagnÉ, were deprived of millions of dollars in professional liability insurance coverage purchased by the firm, by the order of the motion court declaring that the three excess insurance carriers have no obligation to indemnify the firm. The court reasoned that because the law firm knew of misconduct on the part of its client, and of the likelihood that claims would be made against the firm itself based upon its representation of that client while the misconduct took place, it had an obligation to inform the insurers of its knowledge of the misconduct and its concern that it might be subject to suit as a result when applying for coverage or for renewal of coverage. As to two of the insurers, the court precluded coverage under the policies' "prior knowledge" exclusions, and as to the third, it held that the insurer was entitled to rescission of the policy effective the year the claims were made.

The underlying claims against counsel arise out of an alleged securities fraud scheme by the firm's former client, Student Finance Corporation (SFC) and its principal, Andrew Yao. SFC was in the business of financing loans to students in trade schools, primarily truck driving schools; it then pooled the loans into certificates or securities that it sold to investors, using private placement memoranda prepared by Pepper Hamilton. Another client of Pepper Hamilton, Royal Indemnity Company, provided credit risk insurance for the pooled loans.

It is asserted that in order to make its operations appear more successful, SFC falsely represented to investors that student loans in its securitized loan pool were not more than 90 days overdue and in default, when in fact, significant numbers of them were in default. In order to make it appear that student loans in the securitized loan pool were current, rather than more than 90 days overdue, SFC made forbearance payments from reserve accounts of its own. This practice resulted in SFC's understating its default rates, skewing its performance data for the student loans and making the certificates more attractive to investors, underwriters and credit risk insurers.

SFC's inaccurate representation of its default rates apparently began to come to light in or around March 2002, when a round of financing fell through after the lender uncovered SFC's use of forbearance payments through careful scrutiny of its financial documents. Without the new financing, SFC no longer had the liquidity to make up the monthly shortfalls in loan payments. According to GagnÉ, Yao first directly informed him in mid-March of SFC's practice of making forbearance payments for loans that would otherwise be declared in default. While Pepper Hamilton initially continued to represent SFC, after further consideration and interoffice consultation, it withdrew from its representation of SFC on April 24, 2002.

SFC was eventually forced into bankruptcy, and in April 2004, the bankruptcy trustee contacted Pepper Hamilton to request that it enter into a tolling agreement while he considered whether to bring any claims against the law firm. At this point, Pepper Hamilton notified its primary professional liability insurer, Westport Insurance Corporation, of the potential claim; the excess insurers — Executive Risk Indemnity Inc. (ERII), Continental Casualty Company and Twin City Fire Insurance Company — were notified as well.

In November 2004, the bankruptcy trustee commenced an action against the firm and GagnÉ; another action was commenced by Royal Indemnity in March 2005. These underlying professional liability claims against Pepper Hamilton and GagnÉ allege negligence in their failure to discover SFC's securities fraud, as well as actual complicity in SFC's fraudulent scheme.

The coverage issue could not be resolved by summary judgment. According to the court:

The evidence relied upon here, as discussed, simply shows that Pepper Hamilton knew of SFC's misconduct and believed (correctly) that it might itself be subjected to lawsuits brought by parties injured by SFC's actions. The questions of whether Pepper Hamilton gave false answers on Continental's renewal application and whether any such false answers were given in bad faith are questions of fact and cannot properly be determined as a matter of law in the context of a summary judgment motion. Even if we were to accept that the information omitted constituted information that was required by the policy renewal application, Continental fails to establish as a matter of law that if it had been informed of the client's misconduct and the firm's concern about being subject to suit as a result, it would have handled the renewal application differently. The affidavit of an underwriter asserting that, had the information been disclosed, the renewal application would have been handled differently, is not by itself sufficient to satisfy the insurer's burden.